Sharpe Focus is a new podcast series featuring discussions with the Nuance Investment Team. We will be covering topics that we believe our partners will find insightful. Nuance is a boutique value manager that is 100% employee-owned.
The team focuses on buying leading business franchises with sustainable competitive positions that are trading at a discount to our internally derived fair value. We aim to outperform our primary and secondary benchmarks on an absolute and risk-adjusted basis, as measured by Sharpe ratio, over the long term.
In this episode, Portfolio Manager Jack Meurer, CFA®, joins Paul Gillespie to discuss our exposure to the Cargo Ground Transportation sub-industry and why we believe it is a compelling risk reward opportunity within the Industrials sector.
The views expressed are those of Nuance Investments as of the date of this podcast and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation to purchase any security or as investment advice. To view the most current and standardized performance figures available click here for Nuance Mid Cap Value and here for Nuance Concentrated Value. To view the most current top holdings click here for Nuance Mid Cap Value and here or Nuance Concentrated Value.
Investing involves risk, including the possible loss of principal. For more information or a copy of our disclosure brochure, please contact client.services@nuanceinvestments.com. Past performance is not a guarantee of future results.
Paul Gillespie:
Hi everyone, it’s Paul Gillespie from Nuance Investments. I want to welcome you all to our podcast, Sharpe Focus with Nuance Investments. We’ll jump right in today and I’m excited to be joined by one of our portfolio managers, Jack Meurer.
Jack has been with the firm since 2017 when he started on the investment team as an analyst. Since then, he’s worked his way up to portfolio manager, a role he served in for the last couple of years. In addition to his role as portfolio manager, Jack is also our primary analyst in the Industrials sector.
For those of you who’ve paid close attention over the past couple of years, you’ve seen our portfolios go from broadly underweight in the Industrials sector to a much more meaningful position within the portfolio today and as of this recording. It goes without saying that the Industrials sector encompasses a very broad range of companies. When you dig into where we’re seeing opportunities within the Industrials sector today, you’ll see our largest exposure is within the cargo ground transportation sub-industry.
So with that, we’ll jump right in. Jack, it’s great to have you on the podcast today. Appreciate you taking the time to speak with us on the Industrials sector.
Jack Meurer:
Thanks, Paul. I’m looking forward to the discussion.
Paul Gillespie:
All right. Let’s first talk about what exactly is the cargo ground transportation sub-industry where we’re finding these, in our view, unique opportunities.
Jack Meurer:
Yeah. So this is a sub-industry within the broader transportation industry that contains all trucking companies that provide ground transportation services for various types of freight.
So these are primarily asset-based providers, which means they typically own the trucks and trailers, unlike brokerage or logistic companies, which are more asset-light in nature. And these trucking companies offer either less-than-truckload or full-truckload services. And I’ll quickly touch on the distinction between these two types of trucking.
So less-than-truckload operators, which are often abbreviated as LTL, as the name implies, they move less than a full truckload of freight. So they operate kind of a hub-and-spoke model with land, terminals, bays, break-bulk facilities, in addition to the tractors and trailers that they use to consolidate and then move their customers’ freight throughout the country. These companies are moving freight that is too heavy for the parcel companies, so the UPS and the FedExes of the world.
And they primarily serve industrial customers, as well as some big and bulky retail goods. So this includes public companies like Old Dominion (ODFL), XPO (XPO), Saia (SAIA), kind of among that group of companies. The other trucking companies in the sub-industry are full-truckload operators, which will be the topic of the discussion today.
This is where our team is finding the most compelling under-earnings and opportunities. These companies offer services that most people would think of when they think of trucking. So they’re moving full truckloads of freight.
They serve a wide range of industries across the economy, from retail, industrial, food and beverage, consumer products, etc. The truckload industry as a whole moves about 70% of the nation’s freight. And it’s an offering that really hits that sweet spot of low-cost and fast transit times versus other modes of freight transportation.
So you have rail on one end, which is cheap but relatively slow, and you have parcel on the other end, which is fast but relatively expensive. And so trucking kind of falls in the middle of that, and it’s able to meet most customers’ needs. So truckload carriers really provide a vital service to keep the U.S. economy functioning, which is a pretty positive attribute for a business model over time.
Paul Gillespie:
Jack, as most of the people listening to the podcast know, we’re looking for companies that we think have number one, number two market share in their respective sub-industry or niche, and also have what we think of as a sustainable competitive position over the next one, three, five, ten years. What makes the companies that we’re finding within the cargo ground transportation sub-industry leaders? What are we looking for there?
Jack Meurer:
The truckload industry has an interesting market structure. Approximately half of the trucks on the road operate as part of a private truck fleet.
So they serve some or all of the freight needs of companies who have insourced a portion of the trucking function. So some of the larger private fleets are operated by large consumer and retail businesses like Walmart (WMT), PepsiCo (PEP), and Cisco (CSCO), just to name a few. And then the other half of the market is for hire carriers that specialize in offering trucking services for companies that outsource their trucking needs.
It’s estimated that there are over half a million trucking companies that operate in the United States. And interestingly, more than 95% of them operate 10 or fewer trucks. So think of these as small regional mom and pop operators.
The rest of the for-hire market is comprised of larger carriers where their scale and their expertise allows them to have industry leading fleet ages. So, they’re operating the newest, safest, most efficient equipment. It allows them to recruit, to compensate, and retain high quality drivers.
And their larger size allows them to move freight more efficiently using a scaled fleet of trucks where they’re driving less empty trailers, as an example. These larger operators have generally industry leading balance sheet strength as well, which is particularly important given the cyclical boom and bust nature of trucking. A lot of them have been market share leaders and growers over a long period of time, and they generally have high customer retention when their contracts come up for bid.
So, the three trucking companies that we currently own in the portfolio all kind of fit this mold of being leaders. It includes companies like Werner Enterprises (WERN), which is a leading dedicated contract carrier, which means instead of contracting for services on an annual basis, which is how most freight is contracted, they contract with their customers for three to five years at a time, which generally provides higher service levels in exchange for fairly predictable freight volumes and generally a more stable return on capital profile for the carrier. We also own Knight Swift (KNX), which is the single largest truckload operator in the United States, and we own Marten Transport (MRTN), which also has a significant dedicated contract offering and a particular expertise in temperature controlled trucking, so they move a lot of food and beverage and pharmaceutical related freight.
So, all three of these are leaders and have been really excellent operators over a long period of time.
Paul Gillespie:
You mentioned the cyclicality in the space, and that kind of leads me to my next question. So, when you think about any business we follow, we study their returns on capital over a cycle, and we believe there are times to own these businesses when they’re under-earning due to some type of negative transitory event, and there are going to be times where they’re over-earning during very positive transitory events.
Do you mind walking us through the cycle that we’ve seen over the last couple of years within these leaders that you just mentioned within the cargo ground transportation sub-industry?
Jack Meurer:
Absolutely. So, we just talked about the fragmented nature of the for-hire truckload industry, and this is largely a function of the fact that the barriers to entry and truckload are fairly low. In order to enter the industry as an owner-operator, for example, you really just need your commercial driver’s license and a leased truck.
The barriers to exit are equally low, and so what you observe over time is that the supply of trucks and drivers can very quickly respond to cyclically strong and weak pricing signals, which creates this recurring return on capital cycle for truckload companies, and thus opportunities for patient and cyclically aware investors. And so I’ll back up a little bit to provide some context around the current cycle. So, if we go back a few years to the onset of the COVID-19 pandemic, we saw a couple of things worth noting with regard to the truckload industry.
So, in the years following the pandemic, U.S. consumers found themselves spending a lot more time at home, and they also found themselves with improved balance sheets and increased purchasing power due to the receipt of stimulus checks that were sent out by the Treasury in the aftermath of the pandemic. The result was that the U.S. consumer shifted their spending away from services. People weren’t traveling or eating out or going to shows, and they were spending a lot more money on goods, which created a sharp increase in demand for truckload transportation services to move all of those goods.
At the same time, you had driver schools that were temporarily closed due to pandemic restrictions, so this constrained the supply response of trucking and sent pricing for truckload services to peak levels in 2021. You had spot rates that shot up around 60 percent. You had contracted rates that were up 30 to 40 percent, and this took the return on capital for a lot of truckload companies to peak levels.
So, the best-in-class truckload companies that we follow all generate around mid-20s returns on capital through the cycle on our primary EBITDAR to Tangible Asset metric, and during this peak period in 2021, they were generating returns around 30 percent with some of them even above that level, so pretty clear cyclical over-earning at that time. And as we’ve seen time and time again in this industry, these above-normal returns attracted new supply into the market, both in the form of new entrants as well as fleet expansions of existing operators that were chasing these returns on capital, and the result since then has been somewhat predictable. So, the industry went from undersupplied to now oversupplied in pretty short order, which sent spot prices in the exact opposite direction, so down around 40 percent from the 2021 highs.
Contracted rates have been down 25 to 30 percent from the highs, and returns on capital for our favorite truckers consequently went from above-normal levels to now levels that are consistent with historical trough periods in kind of the mid-to-high-teens level, and pretty clearly depressed versus what these operators have done over time and what we believe they can earn through a full cycle. So we’re solidly in a truckload freight recessionary environment as we sit here today.
Paul Gillespie:
You mentioned the leaders in the space that we own, Werner (WERN), Knight (KNX), Marten (MRTN).
I want to spend a few minutes discussing the opportunity, especially you mentioned they were near trough values, we’re in what looks like a recessionary environment for the trucking space or the cargo ground transportation sub-industry specifically. But as it compares to other companies within the Industrials sector, talk a little bit about the opportunities that we’re seeing this, what you just described as broad under-earning in the cargo ground transportation sub-industry. What does that compare to within the broad industrial space?
Jack Meurer:
Yeah, so we just discussed the cycle a little bit, and I think it would be useful to put the magnitude of this cyclical move into perspective as it relates to our particular investments in the space.
And so if you look at Werner (WERN) just as one example, they were earning close to $4 per share at the peak of the cycle. And for this year, per Wall Street consensus estimates, they’re expected to earn about 80 cents per share. Knight Swift (KNX) was earning over $5.50 per share at the peak.
They’re expected to earn around $1 per share this year. And the last one, Martie (MRTN), was earning about $1.35 per share at the peak, and they’re expected to earn around $0.35 per share this year. So earnings have declined pretty sharply across these best-in-class operators, while most industrial companies have experienced earnings growth over this same time period.
And what we’ve seen more recently is that the depressed truckload pricing environment has been pushing the marginal supply of trucks out of the industry, which at least historically speaking, given enough time, ultimately paves the way for a more balanced supply and demand environment, and ultimately recovery and returns on capital for these companies. Over the last couple of years, we’ve seen a pretty steady stream of capacity exits in the space. We’ve seen bankruptcies of poorly capitalized carriers.
And now more recently, we’ve started to see shrinking of fleet size by even the best-in-class larger operators, which we believe will ultimately result in our favorite truckers returning to a more normalized level of returns. So our team has lived through a lot of these trucking cycles, and they take a little bit of time to play out. But all of these truckers that we own as well have great balance sheets and trade at very attractive valuations, where we’re paying about a mid-teens P.E. or so multiple on normalized earnings power, kind of on average for the group as a whole.
And I think this is particularly interesting, and I think a fairly unique opportunity within the broader industrial sector. I think as a generalization, what we’ve observed from a bottom-up basis is that many more cyclical industrial companies have been beneficiaries of what’s been a pretty robust capital spending and growth in recent years, which has led to multiple expansion and many of those industrial stocks that we cover outperforming the broad market. So today, we see more over-earning and valuation than not in the industrial companies that we follow closely, which juxtaposed with very significant under-earning and truly undemanding valuations in these truckload companies.
I think it makes the opportunity even more compelling. And so we’re finding great risk-rewards in the space, and we’re pretty excited about the opportunity looking forward.
Paul Gillespie:
Great. I think that’s a great summary, Jack, and appreciate you taking the time to do this. I think one last thing as it relates to this opportunity, you talked about how fragmented the industry was. And I’m guessing, and I want you to just see if this is where the team’s thoughts are, is that the longer this trough period lasts, the more of those smaller mom-and-pop truckers will go out of business or just cease operations.
And while that can be painful for some of these leaders in the short term, it does create longer-term opportunity, because then they get pricing power, they take market share, and they come out of this stronger. Is that a fair way to summarize this kind of opportunity?
Jack Meurer:
Yeah, I think that’s really fair. I mean, I think what you’ve seen in historical cycles as well is that the weaker hands and really the poorly capitalized carriers are the ones that face bankruptcy and exit the market.
And to your point, that creates opportunity for when supply demand gets more balanced, pricing power improves, it really creates an opportunity for best-in-class truckers that have had great balance sheets to weather the down cycle. It allows them to both take market share organically, and it also allows these companies to potentially grow their business inorganically through doing acquisitions at a very cyclically opportune time as well. And so we’ve seen that historically, we’re seeing some of that today, but I think that’s a very fair observation.
And generally, these cycles will lead to just the continuation of the larger operators incrementally kind of growing their market presence and market share over time.
Paul Gillespie:
Well, thanks, Jack. I appreciate your time today.
I thought it was a great discussion on one of the many opportunities we’re seeing within the portfolio. Again, we would love to hear from any of our listeners with any feedback or follow-up they might have. And we will see you all soon for our next Sharpe Focus with Nuance Investments podcast.
Thanks.
Disclosure:
The views expressed are those of Nuance Investments as of the date of this presentation and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation to purchase any security or as investment advice.
Past performance is not a guarantee of future results. Investing involves risk, including the possible loss of principal. For more information or a copy of our disclosure brochure, please contact client.services@nuanceinvestments.com.
Return On Capital is a calculation that indicates how well a firm can convert capital into earnings. EBITDAR to Tangible Assets is a ratio measuring a company’s EBITDAR in relation to the company’s net fixed assets. The Price to Earnings ratio measures the price of a company’s stock in relation to its earnings per share. The Nuance normalized earnings number is derived internally based on proprietary financial statement analysis. The Nuance price to earnings multiple is the median price to normalized earnings ratio across the Nuance Approved List and is a proprietary calculation.
The holdings identified do not represent all of the securities purchased, sold, or recommended for our clients. As of 09/30/2024 weights of composite names discussed are as follows:
CV: WERN (4.6%), KNX (1.5%), MRTN (1.5%)
MCV: WERN (3.8%), KNX (1.3%), MRTN (1.1%)
The information presented related to the Nuance investment decision and selection process is intended to be informational in nature, speak to our process and does not represent a recommendation in any specific security or securities. Information not specific to a cited source constitutes the opinion of the Nuance Investment Team and should not be relied upon to make investment decisions. Investors should be aware of the risks associated with data sources including without limitation, fundamental, technical, qualitative, and quantitative factors used in our investment process. Errors may exist in data acquired from third party vendors, the development of investment ideas, the analysis of data, and the portfolio construction process. While Nuance takes steps to verify information to minimize the impact of potential errors, we cannot guarantee that errors will not occur.
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